The Federal Reserve is expected to keep monetary policy unchanged over the next few months as the central bank continues to assess the underlying strength of the U.S. economy, especially after the Brexit vote raised concerns that a potential slowdown in the U.K. economy could have a significant spillover effect globally.
Credit Suisse's Global Markets team believes that the vote has, in fact, exacerbated some tendencies within the Fed that were in place long before Britain's June 23 vote to leave the European Union. The team has argued that a deep concern about both economic and market volatility has kept the Fed from raising rates, even as U.S. employment and inflation data have shown consistent improvement. It now believes that U.S. rates will remain at current levels until May 2017.
After two decades of declining GDP volatility, the housing bubble marked a return to large swings in economic growth. But when the bubble burst in 2008, the level of cash flow disruptions and financial instability were greater than the relatively small variation in GDP from boom to bust should have warranted from a historical perspective, the Global Markets team notes, likely because the U.S. financial system is currently more sensitive to sharp changes in GDP growth than it used to be due to the rise of shadow banking and globalization.
When investors lost confidence in the value of asset-backed securities during the crisis, it also became clear that no one really knew who owned problematic assets and in what quantities. Liquidity seized up in fixed-income and short-term funding markets, and problems that originated in the U.S. quickly spread around the world. "We believe policymakers are so scarred by the events of 2008 that they live in constant fear of anything resembling a recurrence," say the Bank's Global Markets economists. "The simplest way to prevent one has little to do with achieving 2 percent inflation and much to do with minimizing the variance of nominal growth, preferably while maintaining full employment."
The Fed has insisted since the beginning of its third quantitative easing program in September 2012 that it is not sensitive to short-term data, but rather "cumulative progress" toward employment and inflation targets. In June 2016, core personal consumer expenditures inflation had been rising steadily and the unemployment rate had been falling, but momentum in jobs growth was slowing, inflation expectations had fallen, and industrial production had declined for three straight quarters. Facing the quandary of positive long-term trends in both areas of its mandate countered by a deterioration in the short-term data, the Federal Open Market Committee adopted a markedly more dovish posture both in a June 16 press conference and the "dot plot" of future interest rate expectations.
Then Brexit - the ultimate volatility event - happened. Credit Suisse's Global Markets economists lowered their U.S. growth forecast for the second half of 2016 from 2.4 percent to 1.9 percent in the wake of the referendum, with the caveat that growth will ultimately depend on the American consumer, who has been powering the U.S. economy for the past few years. Personal consumption has grown an average of 3 percent over the past 11 quarters, faster than the 2.2 percent overall GDP growth rate, driven by rising labor income, improving consumer confidence and increasing credit availability.
While June was another strong month for payroll employment increases, the year-to-date average is 171,000 jobs compared to 240,000 from 2014 to 2015. The slowdown might merely be a consequence of an economy nearing full employment, but labor income trends suggest some downside risks to consumption, with a three-month moving average of aggregate payroll income nearing post-crisis lows in June. If wage growth stagnates or a combination of Brexit and the impending U.S. election deal a blow to consumer confidence, the downside risks to American growth forecasts will increase.
Housing and government spending should still provide tailwinds to growth in 2016, while business investment, which contracted in the first half of the year, should return to positive growth in the second half. That said, the global economy, which is suffering through its fifth-worst slump in industrial production, trade and investment growth since 1980, seems more likely to deteriorate than to improve. After accelerating in the first half of 2016, the Global Markets team expects growth in global industrial production to slow again in the second half, making trade a likely drag on U.S. growth.
Most important for the Fed, however, is the fact Brexit has sown deep-seated doubts about the future. Financial market participants can no longer expect globalization to continue deepening or voters in democratic countries to make market-friendly decisions. "Brexit is different from the euro breakup fears of 2012, the global financial crisis of 2008, or the bursting tech bubble of 2001," say the Global Markets economists. "It is not financial contagion, as in 1998 or this February. Instead, it represents a contagious political development that is hostile to global markets and growth." The volatility the Fed has recently come to fear is likely to stick around for years to come.